Danger lurking in the margins

General insurers have so far largely disregarded the implications of international accounting standards (IAS) for their industry. Yet the proposals, including new discounting rules and market value margins, could have a substantial impact on reserves, reporting, and earnings recognition within the GI sector. They could also transform the comparative profitability of different classes of business. The countdown to IAS is ticking away fast. Yet, for most GI insurers, the proposed new international financial reporting standard (IFRS) is a distant concern, with many believing that it is their counterparts on the life side who have most to fear from the new regime.

Practical priorities Although the draft IFRS seeks to abolish any variation in accounting for life and general insurance contracts, the practical priorities and methods for the respective sectors will be quite different. The new rules will require life insurers to reappraise investment returns, how these interact with liabilities, and how to ensure that guarantees are valued appropriately. In contrast, there is little direct relationship between liabilities and investment returns within general insurance. Instead, the main source of risk and variability is claims payments their amounts and their timings. Therefore, it would appear that it is life insurers who face the greater headache. However, the proposed imposition of new market value margins (MVMs) to reflect risk and uncertainty could prove a minefield for the GI sector, especially when set against the backdrop of wider regulatory moves toward risk-based compliance. This article examines the challenges, and indeed opportunities, of IAS for the GI sector, including changes to the determination of reserves and the impact of IAS on business strategy.

Great change Although some aspects of IAS for insurance have changed since the publication of the draft statement of principles (DSOP) in 1999, the basic planks are still in place. Under the draft IFRS, all prospective cashflows, including a projected best estimate of unpaid claims, will be recorded and recognised when the contract is written. This approach represents a significant departure for non-life insurance, moving away from the traditional accident year basis to an accounting method more akin to an underwriting year basis, with no unearned premium reserve or deferred acquisition costs. While there may be balance sheet benefits in bringing forward the profit, such up-front earnings would also bring forward the tax. As the estimate of unpaid claims will reflect a mean or ‘weighted average of all possible outcomes’, such evaluations are likely to require more sophisticated reserving techniques than are generally used today. In some cases, it will be necessary to supplement standard deterministic modelling with stochastic analysis, using simulations to forecast projected claims payments under different scenarios. Many firms will therefore need to upgrade their systems, especially as any analytical shortcomings will be exposed by the need to disclose variations in the anticipated and realised returns. The determination of unpaid claims reserves will involve discounted claims projections. The discounting will be based on a risk-free rate, rather than the actual investment return on the company’s assets. Firms will also need to augment their reserves with market value margins. While many of the changes described so far could be fairly easy to implement, assessing and validating the MVMs could pose problems. This is especially true for liabilities such as asbestosis, where the source of the claim could stretch back many years and future claims are hard to predict. Even in less contentious areas, the relationship between MVMs and the value attributed to future investment income is such that reserves are likely to rise for some types of business and fall for others. It is unlikely that they will stay the same.

Risk preferences MVMs are designed to reflect risk preference, or the level of compensation over and above the projected liabilities that a potential buyer would demand in return for taking on the seller’s risks. Put simply, MVMs are a cushion for uncertain cashflows. Such uncertainties could include random fluctuations in claims or flawed forecasts of future liabilities. In the 1999 DSOP, the IAS Board tentatively suggested that the value of liabilities, along with the associated MVM, could be derived from a market price (fair value). However, as there is virtually no liquid market for insurance liabilities, the board has moved to the halfway house of entity-specific valuation (ESV). While ESV takes account of the company’s own experience and understanding of the risk and uncertainty it faces in meeting its liabilities, the risk preference element of the MVM would still need to be based on the market.

Grey area Given the obvious difficulties in gauging a market price for insurance risk, the IAS Board has been noticeably vague about exactly how it expects firms to calculate these MVMs. Cynics have suggested that the board has no real idea and has called on the actuarial profession for guidance. It is certainly a problem with no easy or obvious solution. Although some uncertainties mentioned earlier, such as random variation of payments, could be modelled reasonably objectively, assessing others, such as exposure to process risk, will always include an element of subjectivity. The choice of a suitable method will depend largely on the characteristics of the classes of business. Firms will need to gauge the volatility of reserves, taking account of whether the business is in run-off or still being written, the length of the tail, and the ratio of earned to unearned cashflows. A deterministic approach may be appropriate for the more straightforward classes. For example, an MVM of, say, 15% of reserves may be adequate for motor cover in the UK and some other parts of Europe. More complex classes such as excess of loss reinsurance are likely to require stochastic models to assess potential variations in future claims. Suitable software is becoming increasingly available, including systems designed to help UK firms meet the new regulatory requirements outlined in the Integrated Prudential Sourcebook. However, firms will need to look carefully at any additional system and data re-engineering that will be required to meet their particular needs.

Reinsurance Reinsurance will be subject to the same accounting treatment as insurance. Gross discounted claims projections and reinsurance recoveries will be shown separately on the accounts, alongside an MVM for both, before arriving at a net position. The reinsurance recoveries will be shown as an asset, which will be reduced for the risk of default by the reinsurer. Significantly, disclosing the discounted position will spotlight the true cost of most forms of financial reinsurance, leaving them with little scope to flatter the accounts.

Performance reporting Although the IAS Board is still considering its proposals for performance reporting, it seems likely that the proposals will lead to much change in the way accounts are presented. In particular, changes in the ESV or fair value of assets and liabilities may need to be recognised immediately in the income statement. This could lead to volatility in the results, especially if there are marked movements in asset values or interest rates. Inaccurate assumptions for loss ratios on unearned business could cause similar difficulties. To maintain market credibility and confidence, insurers will need to explain any such bottom line fluctuations to analysts, investors, and other stakeholders.

Winners and losers The imposition of MVMs could change the comparative profitability of different classes of business, although the impact may not be immediately obvious. The MVM on earned business will be affected by any volatility in the claims and associated reserves. For short-tailed classes, the MVM will depend more on the volatility of the written unearned business, where the final outcome may differ materially from that expected. Thus the winners are likely to be long-tailed classes with high investment returns and a stable reserving history, which could include some liability classes. Short-tailed policies with stable or predictable loss ratios for instance vehicle cover should also have smaller MVMs, although they will have lower future investment income in any discounting adjustment. The losers will be short-tailed classes with erratic loss ratios and little investment income, such as property/catastrophe reinsurance. The position is less clear for classes such as asbestos, where there are volatile reserving histories but substantial investment earnings.

Grasping the nettle Ultimately, however, there is no absolute rule of thumb to gauge how MVMs and other aspects of the IFRS will affect the business. General insurers will need to undertake a thorough analysis of risk and reserving to ensure that they understand, and are in a position to meet, the new IAS requirements. The transparency of IAS will require IT systems, accounting procedures, and actuarial processes capable of producing accurate and verifiable MVM and cashflow projections. Overestimates would tie up unnecessary amounts of capital in solvency reserves to the detriment of investment and business development. Underestimates could of course lead to damaging losses and undermine the confidence of investors, regulators and rating agencies. Burying one’s head in the sand is clearly a dangerous, though all too common, response to IAS among general insurers. With the EU’s 2005 deadline looming, the time to grasp the nettle is now. In the words of Shakespeare, ‘out of this nettle, danger, we pluck this flower, safety’.